Federal Circuit decision exposes myth that tax treaties solve U.S. double taxation

Dear Congress,

Americans living abroad are frequently told that citizenship-based taxation is not really a problem because tax treaties and foreign tax credits prevent double taxation.

Two recent decisions from the U.S. Court of Appeals for the Federal Circuit expose the weakness of that reassurance. The cases also highlight the broader issue of the United States’ outdated system of worldwide taxation and a fundamental question: if the courts cannot fix it, who can? As the second half of this article explains, only Congress can provide a comprehensive and lasting solution.  The good news is that draft legislation already exists to do so.

In Estate of Paul Bruyea v. United States, decided August 31, the Federal Circuit confronted an unusually clear case of citizenship-based double taxation. Paul Bruyea was a U.S. citizen living in Canada. He sold property in Canada, paid Canadian tax on the resulting gain, and was then required to pay the United States' 3.8 percent Net Investment Income Tax, or NIIT, on the same income. The bill from the IRS came to more than $260,000.

A companion case, Christensen v. United States, decided the same day, told a similar story on a smaller scale. Matthew and Katherine Christensen, U.S. citizens living in Paris, sold shares in a French company, paid French tax on the gain, and were then assessed roughly $3,900 in NIIT on the same proceeds.

Bruyea sought to use the U.S.-Canada tax treaty to prevent that result. Article XXIV of the treaty is aptly titled "Elimination of Double Taxation." It states that "double taxation shall be avoided" and requires the United States to allow credits for Canadian income taxes in specified circumstances.  In effect, Bruyea argued that the tax treaty itself created a tax credit to offset the NIIT tax liability imposed by the United States. 

In both cases, the taxpayers prevailed at trial in the Court of Federal Claims. The Federal Circuit reversed those judgments, adopting the government's narrower reading of the treaty credit provisions.

While the Federal Circuit confirmed foreign tax credits provided under the U.S. tax code generally cannot be used to offset the NIIT, the court also rejected the taxpayers' treaty arguments, holding that these treaties do not independently provide a foreign tax credit against the NIIT where the Code itself forecloses one.  As a result, Bruyea can be taxed by Canada as a Canadian resident and then taxed again by the United States as a U.S. citizen, with the same Canadian income subject to tax under the NIIT. The Christensens received the same answer under the U.S.-France treaty.

While the cases are technically limited to the NIIT and may still be appealed, the significance of the decisions goes well beyond the NIIT. Bruyea and Christensen expose a much deeper weakness in the architecture of citizenship-based taxation: tax treaties may mitigate double taxation, but Americans abroad cannot rely on them to guarantee that double taxation will actually be eliminated.

The clause that changes everything

At the center of the cases is language found in the treaty's double-taxation article.

The United States agrees to provide foreign tax credits "In accordance with the provisions and subject to the limitations of the law of the United States…"  That qualification became decisive.

Ordinarily, the Internal Revenue Code permits foreign tax credits against taxes imposed under Chapter 1 of the Code. Congress placed the NIIT somewhere else: Chapter 2A. The Federal Circuit, therefore, concluded that the Code itself does not permit foreign tax credits to offset the NIIT.

Bruyea's argument went a step further:  the treaty supplied the credit that the Code did not.  The Federal Circuit disagreed. In perhaps the most important sentence in the decision, the court held that "any credit created by Article XXIV of the Convention is, by its own terms, subject to the very Code provisions that foreclose the credit in the first place."

That is a consequential result for Americans abroad.

The treaty promises relief from double taxation. But the Federal Circuit decision held that the extent of that relief is itself made subject to U.S. domestic tax law. And if U.S. law does not permit the credit against a particular tax, the treaty does not necessarily override that restriction.

That interpretation should matter to every American who has been reassured that tax treaties provide a dependable shield against citizenship-based double taxation.

They do not.

While the court’s opinion includes a detailed assessment of the treaty provisions and their interaction with U.S. tax law, along with subsequent changes in domestic law like the NIIT, the court’s fundamental conclusion is that the treaty does not promise the complete elimination of every instance of double taxation. Citing earlier case law, it characterized tax treaties as providing "general protection" rather than "absolute protection" from double taxation. The decisions indicate that Congress can create a new tax, without making foreign taxes creditable against it, and not necessarily violate the treaty's general principle of eliminating double taxation.

This may be the most consequential aspect of the decision. For Americans abroad, "avoidance of double taxation" is not an absolute guarantee that they will not actually be taxed twice.

A key comparison reveals the fundamental problem

The court's opinion contains another revealing argument.

The Federal Circuit questioned whether it would be "anomalous" if a U.S. citizen living in Toronto could receive a foreign tax credit against the NIIT while a similarly situated U.S. citizen living nearby in Buffalo could not. Likewise, the court questioned in Christensen whether there was a basis for assuming that the treaty countries intended to treat a U.S. citizen living in Paris more favorably than a similarly situated citizen living in the United States. But these comparisons illustrate the problem with citizenship-based taxation.

An American living in Toronto and an American living in Buffalo are not similarly situated for tax purposes.

The person in Buffalo is generally subject to one primary, worldwide tax system at the federal level: the U.S. tax code. For the income at issue, the American living in Toronto, in contrast, potentially faces overlapping worldwide tax claims: Canada based on residence and the United States based on citizenship.

Citizenship-based taxation treats these two people as though their circumstances were fundamentally alike. It subjects both to U.S. worldwide taxation and then attempts to repair the resulting conflict for the Canadian resident through foreign tax credits, exclusions, sourcing rules and treaties.

The two cases demonstrate that those repairs have limits.

Importantly, those repair limitations should lead policymakers to reconsider the underlying premise rather than adding yet another patch.

Tax treaties cannot fix the structural problem

The obvious narrow response to both cases would be to amend the Internal Revenue Code so that foreign tax credits can offset the NIIT.  Congress could do that.

The United States could also renegotiate treaties, a much more substantial undertaking that would involve not only the negotiation of NIIT-specific provisions, but potentially also other changes to the treaty depending on the economic and political issues at play once the treaty is reopened.  Importantly, any renegotiation of a tax treaty would require ratification by the U.S. Senate, and likely the treaty partner’s government, which can draw out the process for years.

There will always be differences between the U.S. tax code and the tax systems of the countries where Americans abroad actually live. Countries characterize income differently. They recognize gains at different times. They treat pensions differently. They provide different deductions. They use different tax years, currencies and sourcing rules. And Congress can create new taxes long after a treaty was negotiated, just as those other countries can do.

Foreign tax credits attempt to reconcile those systems after both countries have asserted taxing jurisdiction.  Sometimes they succeed. Sometimes they do not. The Bruyea and Christensen cases tell us that even a treaty article titled "Elimination of Double Taxation" cannot be relied upon to close every gap.

That is not a minor technical defect. It is evidence that the basic system design of the U.S. tax code is backwards.

Residence-based taxation solves the problem at its source

Most countries begin with residence. A person who lives in a country is generally subject to that country's tax system on worldwide income. Other countries retain appropriate taxing rights over income arising within their borders.

The United States instead begins with citizenship. An American who has made a permanent home in Canada, France, Germany, Australia or Japan remains subject to U.S. worldwide taxation indefinitely unless that person relinquishes U.S. citizenship.

We then rely on a maze of foreign tax credits, exclusions and tax treaties to prevent that second layer of taxation from producing unreasonable results.

The Federal Circuit decision has now laid bare the limits of those protections.

Residence-based taxation would reverse the equation.

For qualifying Americans genuinely residing abroad, their country of residence would remain the primary jurisdiction taxing their non-U.S. income. The United States could continue taxing U.S.-source income and preserve appropriate safeguards against abuse. But Americans abroad would not have to rely on treaties and tax credits to undo a second worldwide tax system imposed solely because of their citizenship.

That is a much more durable solution than trying to anticipate every possible collision between the Internal Revenue Code and dozens of foreign tax systems.

An end to an old argument

Defenders of citizenship-based taxation often respond to concerns about double taxation by saying that foreign tax credits and treaties take care of it.  After the Bruyea and Christensen cases, that claim should no longer be made so casually.

The decisions do not mean that tax treaties are useless. Far from it. Treaties remain essential for allocating taxing rights, providing credits, establishing sourcing rules and resolving many forms of double taxation.

But that is precisely the point.  They provide relief, not a guarantee.

Americans abroad should not have to build their financial lives around the hope that a treaty, credit, exclusion or regulatory rules will successfully repair the next conflict created by citizenship-based taxation.  Congress can address the root cause by eliminating the structural problem instead.

The bill that would make the Bruyea and Christensen cases the last of their kind

The Residence-Based Taxation for Americans Abroad Act, originally introduced in the 118th Congress, would let Americans living overseas elect out of the current worldwide U.S. tax system while keeping their citizenship. Broadly speaking, an eligible American abroad who made the election would be taxed more like a nonresident alien, with U.S. taxation generally focused on U.S.-source income rather than worldwide income. Investment income earned and taxed in the country of residence would fall outside the U.S. tax net. For an American who has made the election, the NIIT would simply no longer reach a Canadian home sale or a French stock sale.

Since the bill was introduced in the last Congress, Rep. Darin LaHood and Sen. Todd Young have been working through stakeholders, groups like Tax Fairness for Americans Abroad, and the Joint Committee on Taxation to refine the proposal for reintroduction in the current Congress.  Importantly, the overall objective of the legislation has the backing of President Trump, who pledged during his campaign to end the double taxation of Americans abroad.

If you are an American living abroad, the Federal Circuit has just highlighted where the law stands with all its flaws. Congress is the only place where the U.S. tax law can change and provide lasting relief for American living abroad.

These court cases are not merely about the Net Investment Income Tax. They are a warning about the limits of the entire treaty-based safety net underpinning citizenship-based taxation.

It is time for residence-based taxation.

If you are an American abroad: Write to your representative and your senators, tell them what paying tax twice on the same income, along with all tax compliance burdens, means for your family, and ask them to support the Residence-Based Taxation for Americans Abroad Act.